The potential to aggregate SME volumes has attracted venture and growth capital across a number of sectors, including consumer marketplaces, payments and food delivery. Revenue-based financing appears to be no different. Despite some existing market concerns that a tougher credit environment could negatively impact this vertical, our view is that there remains a strong structural underpinning for long-term growth. We explore this thesis below.
The Opportunity
Small and medium-sized companies usually operate at a working capital disadvantage compared to larger companies. SMEs usually operate with lower supply chain efficiency due to less favourable payable terms and longer lead times. The longer cash conversion cycle means outside financing may be needed to fuel growth and bridge these capital gaps.
Revenue-based financing is a short-term loan used to fill cash flow gaps created by working capital and operating costs. This form of bridge financing is used mainly by ecommerce and SaaS businesses given their higher revenue visibility relative to other sectors, with the loan unsecured but effectively collateralized against future revenues.
In this memo, we aim to do six things.
- Size the potential target market
- Explore key demand drivers
- Unpack the operating model
- Evaluate performance through the business cycle
- Outline possible key risks
- Highlight recent funding levels
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1 – The Target Addressable Market is Significant
We believe there are four ways to assess the addressable market opportunity. Each method suggests the possible market opportunity may be large and under-penetrated.
First, we take the gross merchandises value (GMV) of the top 10 consumer marketplaces (by monthly visits) which largely aggregate online SME sales volumes. This totals almost US$3 trillion. Applying a typical retail gross margin of 50% (higher for SaaS), the potential opportunity appears in excess of $1 trillion for the top 10 marketplaces alone.
Second, we observe the total number of SMEs across five developed markets. In 2021, this equated to almost 10 million small and medium-sized businesses.
Third, we consider SME lending as a percentage of total outstanding loans in the same countries. On average, the SME share of total loan volumes is around 20%, which is low when compared to a 55% average SME contribution to GDP.
Finally, we compare SME financing to the commercial paper market, which raises short-term debt for large enterprises. In the US and Europe alone, the commercial paper market is almost US$2 trillion combined.
2 – Key Demand Drivers
The potential size of the market is not the only attractive attribute, and in our view there are a number of additional drivers to revenue-based loan demand.
High consumer demand – Fiscal stimulus and strong retail growth has meant SMEs have needed greater liquidity to meet short-term working capital needs.
Supply chain disruption – In combination with strong consumer demand, COVID-induced measures has resulted in significant supply chain disruption. Just-in-time inventories are no longer good business practice and embedding greater reflexivity within supply chains means structurally higher levels of working capital are likely to be needed going forward.
Industry fragmentation – As Facebook and Google have consolidated digital advertising dollars over the last 10 years, a growing suite of services are now available to SMEs. This has resulted in many consumer industries becoming more fragmented. That said, since IDFA changes were introduced last year (Identifier for Advertisers, which previously allowed mobile apps to track user behavior) return on ad spend has suffered, with performance marketing dollars being increasingly distributed across other marketing channels, like Tiktok.
New Business Formations – The supply of new businesses increased almost two-fold in 2020 and 2021 versus pre-COVID levels, meaning the number of SMEs has risen. While this trend may mean revert over time, high levels of technological disruption and anti-corporate progressivism remain ongoing tailwinds.
AI/Data Applications – The rising use of AI and data analytics has helped lower credit risk, providing a greater understanding of customer spending patterns and potential revenues. The category leaders are able to reduce default risk to an acceptably low level, which benefits loan volumes.
3 – Operating Model: Demand vs. Supply
There are certain sectors which are probably more attractive to RBF providers including eCommerce and SaaS. eCommerce firms are more able to predict return on ad spend and customer behavioral patterns, and SaaS businesses have contracted revenue. Other sectors which have been targeted by lenders include gaming and app development.
Businesses with a track record of growth (over 6 to 12 months) are preferred given the bankruptcy profile of newly formed companies. For example, on average 18% of US SME businesses go bankrupt within the first year before this profile flattens out over time, according to the BLS.
Understanding seasonality is similarly important, given the first half is typically when ecommerce firms default. Therefore, revenue-based financing companies typically take a smaller fee and shorten duration during 1H, before extending during 2H as merchants benefit from seasonal peaks like Black Friday and Christmas trading.
On the supply-side, there are three types of companies which extend revenue-based financing:
- Pure-play providers
- Payment processors
- Consumer marketplaces
Companies with extensive data insights are best placed to evaluate customer needs and price risk and extend RFB. Recently, incumbent banks have also begun offering SME financing tools, with Barclaycard recently investing £34 million into Liberis, to integrate a cash advance product into their business account offering.
We believe RBF firms have four decisions to make before extending credit to a merchant: Who to lend to? How much to lend? What interest rate? Repayment profile?
We capture the high-level details below for some key players in the market.
In short, there is a five-step process for each transaction:
Step 1: Merchants require short-term financing to meet near-term marketing and working capital needs.
Step 2: RBF companies connect to the merchant’s back-end systems to make decisions based on projected revenues, providing real-time data access via APIs. This creates a circular feedback loop, allowing lenders price risk against current performance, and helping merchants manage key customer metrics and working capital needs.
Step 3: RBF firms set maximum loan amounts against these key metrics, which might include up to a third of ARR, or 4x to 7x MRR. Providers also favour strong CLV:CACs and gross margins above 50%.
Step 4: Repayment fees are agreed which are usually between 6-12% of revenue based on whether you plan to invest the funds in predictable revenue-generating activities.
Step 5: Two methods of repayment exist for merchants. First, variable collection which requires repayment each month based on revenue or gross profits; or second, a flat fee which commits to paying a fixed percentage of your future revenues every month for up to five years, usually at a rate of 1-3%. The second method is preferred by earlier-stage businesses.
4 – Revenue-Based Financing Through the Cycle
There are three key stakeholders in the value chain: the loan provider, the RBF firm and the SME. There are also three main flows of capital.
- First, the loan provider and RBF firm negotiate a forward flow arrangement, where capital providers extend loan capacity and leverage RBF firms origination capabilities. The two parties agree on loan eligibility and advance rates - advance rates reflect the level of over-collateralization demanded by the loan provider. A higher advance rate is more risk-averse and requires higher levels of capital to be held by the RBF company.
- Second, the RBF firm extends credit to the SME as specified by the steps in the previous section.
- Third, the SME repays principal and interest.
Borrowing and lending is cyclical. Volumes rise during expansions as central banks loosen capital requirements and inject liquidity into the economy. During downturns, loan origination contracts as credit risks rise. For revenue-based financing firms there are four fundamental drivers of performance.
- Funding cost: composed of SOFR plus a spread paid to the loan provider
- Advance rate: the level of over-collateralization the RBF firm is required to hold behind gross lending
- Default rate: the proportion of total lending not repaid by the SME and written off
- Interest rate: the rate RBF firms charge SME customers for putting capital at risk. We assume this remains steady at around 8%.
Below we develop a framework to outline the financial profile of an RBF firm through a typical business cycle. We believe there are four basic scenarios when factoring growth and inflation.
Scenario 1: Pre-COVID we operated in a low interest rate environment, where funding costs were relatively low, and advance and default rates more manageable. RBF companies were able to deliver healthy margins, with low levels of collateral required.
Scenario 2: In a period of high growth and low inflation, RBF firms are likely to deliver their highest through-the-cycle returns. However, funding costs are also likely to increase as central banks start to raise interest rates due to strong nominal growth - which starts to compress net interest margins. Advance and default rates are likely to reach cyclical lows.
Scenario 3: In a period of high growth and high inflation, credit spreads start to widen under the threat of slowing growth, causing the cost of debt to rise (risk-free rate may also rise to tame inflation). Advance and default rates also tick higher. Net interest margins are expected to fall through this period.
Scenario 4: In a period of low growth and low inflation, the risk-free rate is likely to fall but credit spreads remain wide as the economy trades through a possible recession. Net interest margins reach their cyclical trough but are likely to progressively improve. Advance and default rates are likely to reach cyclical highs.
In summary, there is a high degree of cyclicality embedded within the business model which presents both risks and opportunities. In our view, RBF firms who are agile around i) duration and ii) loan selection are better placed to manage default risks, retain a stable funding base, and continue to grow loan volumes through the business cycle.
5 – Other Risks Also Exist
In addition to the cyclicality of the business model, there are further risk considerations, some of which we outline below.
- Credit risk: The main risks at the top of the credit cycle are i) lower economic growth and ii) higher default rates. Offering SMEs upfront credit based on future revenue projections has a high level of risk as consumers trade into an uncertain economic environment. However, for earlier-stage businesses cash burn is likely to be more modest, with credit risk also potentially mitigated by predictability in revenue streams.
- Duration Risk: As consumer demand weakens, the duration of the providers’ lending book naturally increases as merchants will need longer to return capital. Providers will probably aim to mitigate duration risk by shortening the incremental loan to new merchants during economic slowdowns.
- Funding Risk: Low interest rates have meant the cost of funding and balance sheet maintenance has been relatively low. As the base rate rises, the ability to pass-through the rate increases to merchants may be impaired as consumer demand slows.
- Merchant risk: SMEs fundamentals are often predicated on high volume transactions with similar-sized businesses, and this circularity of revenue creates inherent risk for merchant sales projections. Default rates as such, may rise. To mitigate this risk, revenue-based financing firms will need to be selective over merchant choice through the application of AI-driven insights.
6 – Funding Environment Has Been Strong since 2021
Venture and growth investment in revenue-based financing began in 2014. In each of the last two years aggregate funding has exceeded US$1 billion according to Pitchbook, as the vertical has benefitted from favourable financing conditions, strong consumer demand and supply chain disruptions.
Recent growth has been mainly driven by Europe and Asia, with the US market still nascent in terms of investment. Europe has exceeded $500 million in 2022TD, with $300 million raised by Wayflyer in May.
Outlook: Scale Players likely to build enduring advantage in structurally growing market
The ability to aggregate SME volumes has been successful across many sectors, and we are positive on the revenue-based financing vertical. While we at an early stage in this nascent market, we can see its potential predicated on a large revenue-based financing opportunity and an under-served SME segment. In our view, structural tailwinds from data analytics and AI applications are also supportive of growth in this market.
However, there are reasons to be cautious in the near-term given the cyclicality of this vertical. This is due to the macro impact of slowing growth and above-trend inflation, which may lead to a rising cost of debt, higher default rates and net interest margin compression.
We believe that companies that are well capitalized with the ability to manage duration through the cycle are most likely see business model resilience. Through an economic downturn the scale players could be more likely to take share, as sub-scale firms may find it difficult to compete on differentiation and price.
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